Keynesian Economics: Great Depression

In the worst year 1933, one-fourth (25%) of the U.S. labor force was
unemployed, and real GDP was 30% below its 1929 level.
This devastating episode caused many economists to questions the
validity of Classical economic theory. Classical theory seemed
incapable of explaining the Depression.
According to Classical theory, national income (Y) depends on factors
of production supplied and the available technology, neither of which
changed substantially from 1929 to 1933.

Keynesian Economics: Great Depression

Keynesian Revolution: In 1936, the British economist John Maynard
Keynes revolutionized economics with his book The General Theory
of Employment, Interest, and Money.
Keynes proposed a new way to analyze the economy, which he
presented as an alternative to Classical theory.
Keynes proposed that low AD (aggregate demand) is responsible for
the low income and high unemployment that characterize economic
downturns.

Keynesian Economics: Great Depression

He criticized Classical theory for assuming that AS (aggregate supply)
alone capital (K), labor (L), and technology determines national
income ().
Economists today reconcile these two views with the model of AD
and AS. In the long run, prices are flexible, and AS determines
national income (Y).
But in the short run, prices are sticky, so changes in AD influence
national income. The model of AD, called IS LM, is the leading
interpretation of Keyness theory.

Investment (I)
Investment spending plays a key role not only in long-run growth but
also in the short-run business cycles because it is the most volatile
component of GDP.
Even though investment is only about 15% of GDP, in the typical
recession half or more of the total fall in spending is reduced
investment.

Three Types of Investment Spending

Business fixed investment: equipment and structures that firms buy
to use in production. In recent years, this component accounts for
about two-thirds of investment, about 11% of GDP.
Residential investment: new housing that people buy to live in and
that landlords buy to rent out.
Inventory investment: those good that firms put aside in storage,
including materials and supplies, work in progress, and finished
goods.

Three Types of Investment Spending

Inventory investment is a small but very cyclical component of
investment. In a booming economy, inventory investment is usually
positive firms are producing more goods than they are selling - but
turns negative during recession; firms cut production sharply and run
down their inventories.

Neoclassical Model of Investment

It examines the benefits and costs to firms of owning capital goods.
The model shows how the level of investment the addition to the
stock of capital is related the marginal product of capital
, the interest rate, income, and the tax rules affecting
firms.
The capital stock changes over time through two opposing channels:
First, the purchase or construction of new capital goods, called gross
investment, increases the capital stock.
Second, the capital stock depreciates or wears out, which reduces
The capital stock.

Neoclassical Model of Investment

Whether the capital stock increases or decreases over the course of a
year depends on whether gross investment is greater or less than
depreciation during the year.
: gross investment during year
: capital stock at the beginning of year
+1 : capital stock at the beginning of year + 1(equivalently, at the
end of year )
: depreciation rate the fraction of capital that depreciates each
year

Neoclassical Model of Investment

. : Capital accumulation equation
+ (+ ) =
Net investment = Gross investment - Depreciation
5.2 : = + +
Thus, gross investment has two parts:
(i) Net increase in the capital stock over the year (+ )
(ii) Investment needed to replace depreciated capital ( )
. : Capital accumulation equation
+ = + = +
Tomorrows capital is increased by investing today less depreciation.

User Cost of Capital

Q: What is the optimal/desired capital stock?
A: It is the amount of capital that allows firms to earn largest
expected profit.
According to neoclassical model of investment, optimal capitals stock
depends on costs and benefits of additional capital.
Since investment becomes capital stock with a lag, the benefit of
investment is the future marginal product of capital .

User Cost of Capital

Q: How much capital should a firm install to maximize profit?
A: For the optimal/desired capital stock, a firm should keep investing
in physical capital until the (future benefit of one more unit of
capital, called marginal benefit) falls to equal the cost of an
additional unit of capital, called the marginal cost.
Real purchase price of capital per unit: To see what variables affect
the equilibrium price of capital, lets consider the Cobb-Douglas
production function, a function many economists believe a good
approximation of how the actual economy turns capital and labor
into goods and services.

User Cost of Capital

Cobb-Douglas production function: = ,
where = output, = capital, = labor,
= a parameter of measuring the level of technology,
and 0 < < 1. measures capitals share of output.
5.4 :
=

= = ()
=

User Cost of Capital

Because the real price of capital
5.5

= equals in equilibrium,

The firm demands a factor of production until marginal product of

capital equals its real factor price; i.e. MB (MPK) = MC ( ).
The lower the stock of capital, the higher the real price of capital:

The greater amount of labor employed, the higher the real price of
capital:
The better the technology, the higher the real price of capital:

User Cost of Capital

Events that reduce the capital stock (a natural disaster), or raise
employment (an expansion in aggregate demand), or improve
technology (a scientific discovery) raise the equilibrium real price of
capital.
Regardless of whether to borrow to buy equipment or to use retained
earnings, firms give up the interest income they would have received
if they invested that money instead of buying new equipment.
Assumption: borrowing rate = lending rate = i or r

User Cost of Capital

Cost of owning a capital: A firm bears three costs for each period of
time.
Interest payment on loans:
Cost of capital loss or gain: (b/c we are measuring costs, not
benefits) where = ,+1 , .
Cost of depreciation: where = depreciation rate.
Example: A firm starts the year with a capital worth $10,000,
but in the beginning of the next year it is only worth $8,000.
= $, ,+ $, , = $, (capital
loss), so = . . The price declined by 20 percent.

User Cost of Capital

5.6 : User cost of capital (uc)

= + =

Meaning: The user cost of capital depends on the price of capital,

the interest rate, the rate at which capital prices are changing, and
the depreciation rate.
User cost of capital
The expected cost of using a unit of capital for a specified period of
time

User Cost of Capital

Assumption: The price of capital goods rises with the prices of other
goods:

= .

5.6 5.7 : = + = +
Meaning: The user cost of capital depends on the price of capital,
the real interest rate, and the depreciation rate.
5.8 : =

+ = + = +

Meaning: Real cost of using a unit of capital for each period of time is
the sum of real interest cost and depreciation.

Example (5.1): User Costs in Nominal Terms

Consider the cost of capital to a car-rental company. The company buys

cars for $30,000 each and rents them out to other businesses. The
company faces an interest rate of 10 percent per year. Car prices are
rising at 6 percent per year, excluding wear and tear. Cars depreciate at
20 percent per year? What is the companys cost of capital?
(Ans.)
the interest cost = 0.1 $30,000 = $3,000
capital gain = 0.06 $30,000 = $1,800
loss due to depreciation = 0.2 $30,000 = $6,000
= + = $3,000 $1,800 + $6,000 = $7,200.
The cost to the car-rental company of keeping a car in its capital stock
is $7,200 per year.

Example (5.2): User Costs in Real Terms

Consider a bread company that produces specialty cookies and that is

considering investing in a new solar-powered oven that will allow it to
produce more cookies in the future. In making a decision, it has the
following information:
A new oven can be purchased in any size at a price of $100 per cubic
foot, measured in real (base-year) dollars.
Because the oven is solar powered, using it does not involve energy
costs. The oven also does not require maintenance expenditures.
However, the oven becomes less efficient as it ages: With each year
that passes, the oven produces 10% fewer cookies. Because of this
depreciation, the real value of an oven falls 10% per year.

Example (5.2): User Costs in Real Terms

The company can borrow (from a bank) or lend (to the government, by
buying a 1 year government bond) at the prevailing interest rate of 10%
per year. The price level is expected to rise at 2%.
What is the companys user cost of an oven per cubic foot per year?
(Ans.)
real interest cost = 0.08 $100 = $8
depreciation cost = 0.1 $100 = $10
= + = $8 + $10 = $18.
The companys user cost is $18 per cubic foot per year.

Determination of the Optimal Capital Investment

Now consider a firms decision about whether to increase or decrease
its capital stock.
Revenue: = (, ) where = (, ).
Cost: + +
Profit = Revenue Cost
= , +
First-order necessary condition for profit maximization:

+ =

5.9 : = ( + )

Determination of the Optimal Capital Investment

= ( + )
A firm should invest until the value of extra output that capital
produces falls to equal the user cost.
Benefits of investing are more output tomorrow so, it is future MPK
that is important. Investment decisions today have effects on the
capital stock tomorrow.
Divide 5.9 by :

. : =

Determination of the Optimal Capital Investment

> ( > )
Profits rise as K is reduced: Invest less than what necessary to
replace the depreciated capital.
< ( < )
Profits rise as K is added: Invest more than what necessary to
replace the depreciated capital.
A firms optimal/desired capital stock is where =
( = ): Profits are maximized.

Figure 5.1: Determination of the Optimal Capital Stock

Determination of the Optimal Capital Investment

Q:Why does the curve slope downward?
A: falls as the capital stock (K) is increased due to diminishing
marginal productivity (or decreasing returns to capital).
Mathematically, =

2
2

= 1 1

= 2 1 < 0 since 0 < < 1.

Q: Why is the user cost curve a horizontal line?

A: Because the user cost doesnt depend on the amount of capital:
uc doesnt vary with K. Mathematically,

(+)

= (zero slope horizontal line)

Determination of the Optimal Capital Investment

The desired/optimal amount of capital for the firm to own occurs at
the intersection of the marginal product with the user cost of capital:
= . At this point, the extra output produced by one
additional unit of capital is precisely enough to cover the extra cost of
owning a unit of capital, the user cost.
When the capital stock reaches a steady-state level
= ( + ). Thus, in the long run, the marginal product of
capital equals the real cost of capital.

Determination of the Optimal Capital Investment

The speed of adjustment toward the steady state depends on how
quickly firms adjust their capital stock which in turn depends on how
costly it is to build, deliver, and instill new capital.

Changes in the Optimal/Desired Capital Stock

Factors that shifts the curve or change the user cost of capital
cause the optimal/desired capital stock to change.
An increase (or a decrease) in interest rate leads to a decrease
(or an increase) in the optimal capital stock.

Figure 5.2: An Increase in Interest Rate

An Increase in Interest Rate

The interest rate rises from to
The rise in the user cost leads to an upward shift of the user cost
line, from 1 to 2
After that shift, the at the initial optimal capital is less than
the user cost of capital: < < .
The optimal capital stock decreases from to .
Summary: Any other change that increases (or decrease) the user
cost of capital decrease (or increases) the optimal capital stock.